Krugman on the U.S. corporate tax rate

There's been a lot of focus in tax policy circles on the contention that the U.S. corporate rate is too high, leading to one or more of the following claimed ill effects: (1) competitive disadvantage to U.S. companies abroad (which might or might not affect U.S. national welfare), (2) reduced investment in the U.S., including the inbound, and/or (3) the shifting of reported taxable income, and thus tax revenues, out of the U.S. to other countries with lower rates. It's clear that the U.S. corporate rate, 35%, is these days a bit of an outlier on the high side.

But is that the number that matters? Paul Krugman thinks not:

"Now, the thing you have to realize about corporate taxes is that the statutory rate — the rate you pay after [being] allowed deductions and all that — means very little. That’s because corporations have lots of potential deductions — and can hire the very best accountants to find them, and lawyers to justify them. So any time you see a table that compares the nasty 35% US rate with other countries, you know you’re being snowed.

"A much better indicator is the amount of taxes corporations actually pay. From OECD data (behind a paywall, I think, unfortunately), I get the following for percentage of GDP paid in corporate taxes in some major economies, in 2005:

Canada 3.5
US 3.1
Japan 4.3
France 2.8
Germany 1.7
UK 3.4."

Point taken about the statutory rate standing alone. But that's not to say that Krugman's preferred indicator is any better, or indeed as good. For starters, one has to ask how much economic activity in a given country, relative to GDP, is run through corporations, rather than other forms. Does the U.S. have a greater tendency for business activity to run through partnerships, etcetera? In other words, the correct denominator of the fraction is not necessarily national GDP. For a first cut it's corporate economic activity, though even that isn't quite right because you have to think about the consequences of shifting activity around into or out of corporate solution (and how that's taxed).

Not to mention that the second, shareholder level of tax is important to the assessment as well, although that raises further complications that I won't get into here.

Also, if we are mainly concerned about incentive effects, efficiency, and net U.S. national economic welfare, rather than distribution - and I think that is the main long-term issue here, as I'll explain in a moment - then it's not the average but the marginal U.S. corporate tax rate that we care about. So, insofar as companies can play games to save some tax inframarginally, but can't get to zero or boost up their sheltering when they make more profits, it's possible that they would be paying closer to 35% than to their average rates at the margin. I'm not asserting this, but merely noting that it's possible and that the data Krugman cites don't address it.

But is this a distribution issue, not one of efficiency? Krugman presumably thinks so, and he has a point. Taking as given the level of corporate investment et al, which reflects expectations about effective tax rates, if we then in practice lower or raise the overall corporate effective rate the winners or losers are probably corporate shareholders, who on average are relatively affluent. This is the transition incidence of an unanticipated change in the level of the corporate tax. Thus, corporate shareholders would presumably win (all else equal) from lowering the corporate rate to 25%, given that such a change (though being debated) presumably is not, at this point, considered anywhere close to certain. But if we are talking about a stable equilibrium level of effective taxation of corporate income, then it all depends on the incidence of this tax - which economists increasingly believe, in the open economy era, falls largely on labor rather than capital. (See my forthcoming corporate tax book with the Urban Institute Press, "The U.S. Corporate Tax - What Is It and Where Is It Headed?" - due out in early 2009 - for a fuller discussion of these points.)